Boom2Bust.com

I.O.U.S.A.

For those of you looking for some feel-good cinema this summer, you may want to pass on the movie “I.O.U.S.A.,” which debuts August 21. Frank Ahrens of the Washington Post wrote Thursday:

A private-equity billionaire, a former federal government official and a Baltimore newsletter editor have made a documentary film that they hope can do what an endless parade of policy papers has not: Persuade Americans that debt has created a looming economic crisis that would make the Great Depression look like a market correction.

The movie, “I.O.U.S.A.,” debuting Aug. 21, is an 87-minute alarum on what it calls the tsunami of debt bearing down on the United States’ future, caused by the rising national deficit, the trade imbalance and the pending costs of baby boomers cashing in on entitlements…

The film will debut in 400 theaters around the country on Aug. 21, followed by a live video town hall meeting from Omaha, featuring Walker, Peterson and Buffett. The next day, the film opens in 10 cities, including Washington.

From the movie’s website:

Wake up, America! We’re on the brink of a financial meltdown. I.O.U.S.A. boldly examines the rapidly growing national debt and its consequences for the United States and its citizens. Burdened with an ever-expanding government and military, increased international competition, overextended entitlement programs, and debts to foreign countries that are becoming impossible to honor, America must mend its spendthrift ways or face an economic disaster of epic proportions.

Throughout history, the American government has found it nearly impossible to spend only what has been raised through taxes. Wielding candid interviews with both average American taxpayers and government officials, Sundance veteran Patrick Creadon (Wordplay) helps demystify the nation’s financial practices and policies. The film follows former U.S. Comptroller General David Walker as he crisscrosses the country explaining America’s unsustainable fiscal policies to its citizens.

With surgical precision, Creadon interweaves archival footage and economic data to paint a vivid and alarming profile of America’s current economic situation. The ultimate power of I.O.U.S.A. is that the film moves beyond doomsday rhetoric to proffer potential financial scenarios and propose solutions about how we can recreate a fiscally sound nation for future generations.

I know where I’ll be August 21…

Trailer, “I.O.U.S.A.” (2008)
YouTube Video Link

Source:

“Indebted Ever After”
Frank Ahrens
Washington Post, August 7, 2008

Twin Deficits, Twice The Pain

It was all bad news today with the release of the latest data on the “twin deficits”— the U.S. budget and trade deficits. The Associated Press reported Thursday that the federal deficit through the first half of the budget year is at an all-time high. The U.S. Treasury Department said Thursday that the budget deficit through the first six months totaled $311.4 billion, which is up 20.5% when compared to the $258.4 billion deficit through the first six months of 2007. The previous record of $302 billion was set in 2006.

Back in February, the Bush administration was projecting that the deficit for the whole year would total $410 billion. The Associated Press wrote today:

However, private economists are forecasting a much bigger deficit, reflecting the country’s current economic problems and a $168 billion stimulus package that Congress has passed in an effort to jump-start growth.

While the trade deficit data released by the U.S. Department of Commerce today didn’t set any records, it wasn’t much rosier. MarketWatch senior reporter Greg Robb wrote:

The U.S. trade deficit widened unexpectedly in February, painting an even gloomier picture for the economy.

The 5.7% increase wasn’t even caused by the two factors usually cited as culprits — imports of oil from the Middle East and imports of inexpensive goods from China. Rather, the widening of the deficit came about as a result of record imports of food, industrial supplies, capital goods and consumer goods.

The nation’s trade deficit expanded to $62.3 billion, broader than the revised figure of $59.0 billion for January, the Commerce Department said.

February’s gap is the largest and the biggest one-month worsening in the deficit since November.

Sources:

“Mid-year budget deficit at all-time high”
Associated Press, April 10, 2008

“U.S. trade gap widens unexpectedly”
Greg Robb
MarketWatch, April 10, 2008

Next Stop, Depression?

Back on March 29, ABC News’ David R. Francis talked about the economic forecast of Robert Parks, a finance professor at Pace University and former chief economist at three Wall Street firms. So, what’s so special about Parks that ABC News would be covering him? According to Francis, Parks is predicting that there is more than a 60% chance the United States will enter into an economic depression.

Even though the Federal Reserve has been cutting interest rates to stimulate the economy, Francis wrote:

Mr. Parks, however, doubts the cuts will do much to boost the economy. Rather, he sees a further steep fall in housing prices, continued major deficits in the federal budget and in the international trade balance, a tumbling dollar, and a weak stock market leading to a genuine depression with 30 to 35 percent unemployment, greater poverty, more loss of homes, plunging bond and stock prices, even some starvation.

Mother and child during Great Depression

Source: FDR Presidential Library & Museum

He also noted that Parks says he has never predicted a depression before.

The economist thinks that it’s a mistake to rely on money supply growth to help alleviate present economic conditions. Francis wrote:

As Parks sees it, Washington and Wall Street are mostly counting on Fed additions to the money supply to revive the free market and right the economy.

“Automatic recovery is in no way a reliable concept,” he warns, especially if deflation (falling prices) has begun. He recalls warning of the economic damage that the bursting real estate and stock market bubbles would wreak in Japan: That nation suffered stagnation from 1990 to 2001.

Source:

“Are We Heading Into a Depression?”
David R. Francis
ABC News, March 29, 2008

Why Americans Should Worry

Let me tell it to you straight. The. Math. Politicians. Sell. Does. Not. Work. And if we don’t start dealing with the truth soon, this country could face dire consequences.

-David L. Walker, Comptroller General of the United States, October 2007

On February 15, David M. Walker, Comptroller General of the United States, announced his resignation as head of the U.S. Government Accountability Office (GAO). Since November 9, 1998, Walker has served as the nation’s chief accountability officer, leading the GAO in its mission to help improve the performance and accountability of the federal government for the benefit of the American people. Back on February 15, Richard Cowan wrote in Reuters that:

Walker repeatedly urged Congress to waste no time in reforming massive government programs, such as health care for the elderly, which will grow significantly as the U.S. population ages.

“The picture I will lay out for you… is not a pretty one and it’s getting worse with the passage of time,” the blunt-talking Walker told Congress more than once.

Despite those warnings, Congress and the White House have yet to begin cooperating on how to tackle the huge growth in health care and retirement benefit costs.

Back on December 18, 2007, I wrote:

On Monday, the Bush administration released its Financial Report of the United States Government for the 2007 budget year. And guess what? The U.S. government is promising $45 trillion more than it can deliver on Social Security, Medicare, and other benefit programs, according to the Associated Press yesterday…

Even worse, when the gap in funding social insurance programs (Social Security, Medicare, Railroad Retirement, and Black Lung Program) is added to other government commitments, the total shortfall as of September 30 increases to $53 trillion, up more than $2 trillion in just a year, according to the report. Comptroller General David M. Walker, who serves as the head of the Government Accountability Office (GAO), said Monday that, “Our government has made a whole lot of promises in the long-term that it cannot possibly keep.”

Yesterday, Bill Donoghue from MarketWatch had this to say about Walker’s departure:

Facing indifference on the Hill and unrealistic spending promises, Walker is resigning with five years still remaining in his term to head the newly formed Peter G. Peterson Foundation. Peterson, senior chairman of The Blackstone Group and Commerce secretary in the Nixon administration, has pledged an astounding startup budget for the foundation of $1 billion.

That money will attack what the foundation considers “the most substantial economic, fiscal and other sustainability challenges of our current age” — including federal entitlement programs, health care, unprecedented trade and budget deficits, low savings rates, mounting foreign debt, soaring energy consumption, an uncompetitive educational system, and the proliferation of nuclear warfare materials. Maybe Congress will listen this time.

The departing Comptroller General told Reuters:

As Comptroller General of the United States and head of the GAO, there are real limitations on what I can do and say in connection with key public policy issues, especially issues that directly relate to GAO’s client — the Congress.

My new position will provide me with the ability and resources to more aggressively address a range of current and emerging challenges facing our country.

MarketWatch’s Donoghue lamented:

This sounds to me like the ultimate sell signal on America…

When the nation’s best-informed watchdog resigns and few are acting on his recommendations on his “Fiscal Wake-Up Tour,” it’s time to reconsider over-optimistic domestic stock investments and look elsewhere, or bet against the U.S. market.

Source: stock.xchng

The “Fiscal Wake-Up Tour” is a joint public engagement initiative by the Concord Coalition, the Budgeting for National Priorities Project at the Brookings Institution, and the Heritage Foundation, created for the purpose of explaining in plain terms why budget analysts of diverse perspectives are increasingly alarmed by the nation’s long-term fiscal outlook.

(Note: The author disclaims any personal liability, loss, or risk incurred as a consequence of the use and application, either directly or indirectly, of any information presented herein.)

Father of Reaganomics: Nothing Can Be Done To Save Economy

This morning I came across an interesting article by Paul Craig Roberts in the Coastal Post. Who is Dr. Roberts? He is an economist who served as an Assistant Secretary of the Treasury in the Reagan Administration, and is known as the “Father of Reaganomics.” Outside of the public sector, he was a former editor and columnist for the Wall Street Journal and Business Week.

What initially caught my eye was the title of the article- “The Impending Destruction Of The U.S. Economy.” No use beating around the bush. But he did manage to beat up the Bush administration and other policymakers in Washington for their mishandling of the U.S. economy. Dr. Roberts wrote:

Hubris and arrogance are too ensconced in Washington for policymakers to be aware of the economic policy trap in which they have placed the U.S. economy. If the subprime mortgage meltdown is half as bad as predicted, low U.S. interest rates will be required in order to contain the crisis. But if the dollar’s plight is half as bad as predicted, high U.S. interest rates will be required if foreigners are to continue to hold dollars and to finance U.S. budget and trade deficits.

Which will Washington sacrifice, the domestic financial system and overextended homeowners or its ability to finance deficits?

The answer seems obvious. Everything will be sacrificed in order to protect Washington’s ability to borrow abroad. Without this, Washington cannot conduct its wars of aggression, and Americans cannot continue to consume $800 billion dollars more each year than the economy produces.

Nice job, Washington!

However, this line of credit is threatened. According to Roberts:

No country wants to hold a depreciating asset, and no country wants to acquire more depreciating assets. In order to reassure itself, Wall Street claims that foreign countries are locked into accumulating dollars in order to protect the value of their existing dollar holdings. But this is utter nonsense. The U.S. dollar has lost 60 percent of its value during the current administration. Obviously, countries are not locked into accumulating dollars…

Japan and China - indeed, the entire world - realize that they cannot continue forever to give Americans real goods and services in exchange for depreciating paper dollars. China is endeavoring to turn its development inward and to rely on its potentially huge domestic market. Japan is pinning hopes on participating in Asia’s economic development.

The dollar’s decline has resulted from foreigners accumulating new dollars at a lower rate. They still accumulate dollars, but fewer…

Foreigners have continued to accumulate dollars in the expectation that sooner or later Washington would address its trade and budget deficits. However, now these deficits seem to have passed the point of no return.

Faced with the realization that the twin deficits will not be addressed, will foreigners finally stop accumulating dollars and/or significantly reduce dollar holdings, causing a dollar crash?

Dr. Roberts explained why the twin deficits could no longer be fixed:

The sharp decline in the dollar has not closed the trade deficit by increasing exports and decreasing imports. Offshoring prevents the possibility of exports reducing the trade deficit, and Americans are now dependent on imports (including offshored production) for which there are no longer any domestically produced alternatives. The U.S. trade deficit will close when foreigners cease to finance it.

The budget deficit cannot be closed by taxation without driving up unemployment and poverty…

In the 21st century, the U.S. economy has been driven by consumers going deeper in debt. Consumption fueled by increases in indebtedness received its greatest boost from Fed chairman Alan Greenspan’s low interest rate policy. Greenspan covered up the adverse effects of offshoring on the U.S. economy by engineering a housing boom. The boom created employment in construction and financial firms and pushed up home prices, thus creating equity for consumers to spend to keep consumer demand growing.

This source of U.S. economic growth is exhausted and imploding. The full consequences of the housing bust remain to be realized. American consumers lack discretionary income and can pay higher taxes only by reducing their consumption. The service industries, which have provided the only source of new jobs in the 21st century, are already experiencing falling demand. A tax increase would cause widespread distress.

The old-school Republican had this to say about our precarious position:

Superpower America is a ship of fools in denial of their plight. While offshoring kills American economic prospects, “free-market economists” sing its praises. While war imposes enormous costs on a bankrupt country, neoconservatives call for more war and Republicans and Democrats appropriate war funds, abroad….

We have arrived at the point where it is no longer bold to say that nothing now can be done. Unless the rest of the world decides to underwrite our economic rescue, the chips will fall where they may.

Vanguard Founder Says Recession Odds At 75 Percent

Earlier today, CNN Money posted the answers to questions Fortune readers asked of John Bogle, the 78-year-old founder of mutual fund giant Vanguard. With $1.3 trillion in assets, Vanguard is now the second-largest mutual fund company. Bogle talked about the odds of a U.S. recession, the U.S. housing market, the subprime crisis, and challenges to the U.S. economy, among other issues.

What are the odds of a recession right now?

I would put the odds of a recession at 75 percent. This economy is very much consumer-based, and I believe that 70 percent of the GDP is consumer spending. That’s a very high number. Two things are happening there: Consumers have fewer resources because from 2001 to 2005 they took $5 trillion out of real estate. That will not recur. This is a big drop. We also see weakness in auto sales and retail spending - we even see it at companies like Starbucks. There is another, equally important factor in consumer spending, and that is confidence. Consumers are not going to spend if they are worried about the future.

Will the real estate market improve anytime soon?

It doesn’t look so good. I really don’t see it improving soon. At some point homes will have to be built. But right now there is not much incentive to build new places when there are so many old places on the market. When those lines cross I don’t know. It’s complicated by the fact that many people have gotten into ARMs [adjustable-rate mortgages] who didn’t know what they were doing. I don’t know what is going to happen to those people when lenders foreclose. When banks were community banks, they were more careful. But when banks sell loans in a bundle, they are clearly not going to be concerned about mortgage quality. So we have to have a better system in the future to make sure we have a much better element of credit quality in mortgages.

How does the U.S. subprime mess compare with other crises you have seen in your career?

I’d say the most similar example was the S&L crisis of the late ‘80s and early ‘90s. The issues were somewhat the same: Institutions borrowed short and lent long.

The immediate concern for most investors is the subprime market, but over the long term what do you see as the biggest challenges facing the U.S. economy?

Externally, we are faced with $1.5 trillion already poured into Iraq and Afghanistan. So you have enormous expenditures in a corner of the world that is important to us, but it is very unwise to think we can bring democracy to a place that doesn’t share our values. There are also the challenges from low cost production in China and India. At home, we have a tremendous future financial problem with the federal deficit. We’ll have to take action on Social Security someday. Government spending has gotten to the point where we will have to either cut spending or raise taxes. Another problem is this deadlocked Congress. And I see the quality and caliber of our presidential nominees, and I am not impressed.

It raises the question of whether this country is even able to run itself anymore.

U.S. Budget Deficit Could Suffer ‘Noticeable Deterioration’

Today, Congressional Budget Office Director Peter Orszag told the House Budget Committee that subprime mortgage woes and other factors have combined to create an “elevated risk of a recession,” according to MarketWatch. However, Orszag emphasized that the most likely scenario was “low economic growth,” pointing to the general consensus of analysts.

His testimony was notable in that he pointed out that a recession or extended stretch of sluggish growth could cause a “noticeable deterioration” in the U.S. budget deficit. A budget deficit occurs when the U.S. government spends more money than it takes in. Orszag pointed out that the U.S. deficit has increased by around 1% to 3% of gross domestic product during recessions since 1968, or $140 billion to $420 billion in today’s economy. For fiscal year 2007 (which ended September 30), the deficit stood at $162.8 billion, according to U.S. Treasury data.

Source: White House

On December 3, Bloomberg said a growing number of strategists are saying the stage is being set for a U.S. dollar rally in 2008. They have been pinning their hopes on the simultaneous narrowing of the U.S. budget and trade deficits for the first time since 1995. Stephen Jen, the London-based head of currency research at Morgan Stanley, told Bloomberg, “I am confident that the dollar will have a significant rally next year, especially against the euro and the pound… The deficits are shrinking fast.”

For how much longer?

Buffett The Dollar Slayer

When E.F. Hutton, er, Warren Buffett speaks, people listen. The “Oracle of Omaha,” the legendary stock market investor now worth $52 billion according to Forbes magazine in March, told reporters during his first trip to South Korea that he expects the U.S. dollar to weaken further. Buffett said, “We are still negative on the dollar. We bought stocks in companies that are earning their money in other currencies,” while visiting a Berkshire Hathaway subsidiary in that country. “We are gaining foreign currency exposure that we like,” Buffett added. The dollar fell against its major counterparts earlier today, after a larger-than-expected decline in the durable-goods orders for September increased market expectations of an interest rate cut by the Fed.

The 77 year-old investor also weighed in on the subprime mortgage crisis in the United States. Buffett said that the subprime problem could last anywhere from another 6 months to 2 years.

Warren Buffett has been negative on the U.S. dollar for quite some time now. If you recall, back on June 14 I talked about his outlook for the greenback:

On October 26, 2003, Warren Buffet wrote a piece for Fortune entitled “Why I’m not buying the U.S. dollar.” Although a little dated, this article, and Buffett’s subsequent bet against the dollar, gives us insight as to where Mr. Buffett thinks the U.S. dollar and economy are going. Buffett said, “I started way back in 1987 to publicly worry about our mounting trade deficits — and, as you know, we’ve not only survived but also thrived. So on the trade front, score at least one ‘wolf’ for me. Nevertheless, I am crying wolf again and this time backing it with Berkshire Hathaway’s money.”

According to an October 18 Reuters article, Buffett bet more than $21 billion against the U.S. dollar amid concerns over mounting U.S. trade and current account deficits.

Sunday Edition: October 21, 2007

Something Wicked This Way Comes
It was only a matter of time before prices at the pump went up with oil hovering around $90. According to the nationwide Lundberg survey of about 7,000 gas stations, the national average for self-serve regular unleaded gas was nearly $2.80 a gallon on October 19, up 4.92 cents per gallon in the past 2 weeks. Survey editor Trilby Lundberg told Reuters this weekend that:

While gasoline prices moved up just under a nickel in that period, crude oil prices are up the equivalent of 18 cents per gallon. That missing 13 cents and more will probably turn up at the pump and soon because it represents margin squeeze over months for refiners, jobbers and retails — those who make, deliver and sell gasoline.

At $2.80 a gallon, gas prices are 60 cents more than at this time last year. The all-time high of more than $3.18 was reached back on May 18, 2007. High gas prices act as a drag on the economy. The more they rise, the more consumers have to spend on fuel and the less they have to spend on other goods and services, which drives the U.S. economy. Lundberg noted that the average price is likely to exceed $3 per gallon in coming weeks.

G-7, G-Whiz
Talk about sending the wrong message. The Group of Seven (G-7) finance chiefs ended their weekend meeting without offering verbal support for the U.S. dollar.
The G-7 consists of the United States, Japan, Germany, France, Britain, Italy and Canada. G-7 finance ministers meet several times a year to discuss economic policy. While the officials urged China to speed up appreciation of the yuan, it did not comment on the prevailing dollar weakness against other currencies, most notably the euro. Analysts have said this silence was largely expected, since U.S. leaders are hoping a weakened currency will boost American exports and reduce the massive current account deficit. Yet, should the decline in the dollar’s value continue to accelerate, foreign investors may sell their dollars and move their cash into other markets where interest rates are rising and whose economies appear better off. The American economy will suffer. An Associated Press article from September 25 talked about such a scenario:

If foreigners’ buying habits change, that could have a broad impact on financial markets- and U.S. consumers, too. For instance, if they sell their U.S. Treasury holdings, or don’t buy new government bonds or notes, then Treasury prices will go down and yields will go up. That will likely send mortgage rates higher since they are pegged to the 10-year Treasury note. That could unravel any good that has come from the Fed’s rate-cutting action and put the economy in a precarious spot. It makes you wonder why this administration isn’t doing more- or anything- to help the dollar.

Currency traders interpreted the silence as meaning official attempts at propping up the greenback are unlikely, according to Reuters earlier today. Michael Woolfolk, senior currency strategist at The Bank of New York Mellon, said “The G7’s statement effectively gives a green light to continue selling the dollar.” Traders may refocus this week on slower economic growth in the U.S., high oil prices, and the housing slump. Phyllis Papadavid, currency strategist at London-based Societe Generale, told Reuters that, “There’s acknowledgment that the fundamentals in the U.S. economy aren’t up to scratch at the moment, and in that regard the dollar isn’t in the clear.”

The greenback has been falling for more than 5 years now, and recently hit a new low against the euro and 26-year low against the pound. While the U.S. dollar lost 8% of its value last year against a basket of foreign currencies, it is already down another 7% to date. Still, Washington claims to support a strong dollar policy. On October 16, U.S. Treasury Secretary Henry Paulson said:

In terms of the upcoming G7 … the strong dollar is in our nation’s interest. I have said repeatedly that, and currency values should be determined in competitive markets, based on underlying economic fundamentals.

Actions speak louder than words, Mr. Secretary.

Follow Through
In a post from last Thursday, I talked about how overseas private investors sold a record amount of U.S. securities in August. According to the U.S. Treasury Department earlier in the week, the total holdings of equities, notes, and bonds fell a net $69.3 billion, after an increase of $19.5 billion in July. The outflow from U.S. assets was a record high and the first since the financial market crisis back in 1998.

You may be interested to know that former Federal Reserve Chairman Alan Greenspan said in a speech earlier today that the recent performance of the U.S. dollar may be tied to overseas investors unwilling to buy more U.S. debt. Speaking from Washington, D.C., Greenspan said, “Obviously there is a limit to the extent that obligations to foreigners can reach.” According to Bloomberg, the popular, yet controversial, economist noted that the dollar decline may be “an indication America is approaching this limit.”

Parting Shot
Back on July 2, I wrote about U.S. Treasury Secretary Henry Paulson and his views on the troubled U.S. housing sector:

The former chairman of Goldman Sachs stated that the downturn in the housing market is “at or near the bottom. It’s had a significant impact on the economy. No one is forecasting when, with any degree of clarity, that the upturn is going to come other than it’s at or near the bottom.”

In my August 1 post, I talked about how Secretary Paulson felt that housing’s economic fallout was contained:

According to Reuters, “Paulson added that he did not see anything that caused him to reconsider his view that the economic damage from the housing correction was ‘largely contained,’ despite losses in a number of financial institutions and a long period for subprime issues to move through the economy.”

Fast forward to October 16. The former Goldman Sachs chairman had this to say to Georgetown University’s law school:

But let me be clear, despite strong economic fundamentals, the housing decline is still unfolding and I view it as the most significant current risk to our economy. The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth.

Good grief…

Have a wonderful week,

Christopher E. Hill
Editor
editor@boom2bust.com

Goodbye Yankee Dollar

Amid growing expectations of a slowing U.S. economy and potential interest rate cut by the Federal Reserve, the U.S. dollar fell to a new record low against the euro. Earlier on Wednesday the euro touched $1.3913, its highest level since the European currency was launched back in January 1999. “It’s all about lower growth, lower rate expectations now,” Gregory Salvaggio, senior currency trader at Tempus Consulting in Washington, told Reuters this afternoon. He added, “That combination is fueling a shift to the euro, especially ahead of the Fed’s meeting next week, and now that we broke $1.39, the next one at $1.40 is within sight.” Jonathan Cavanagh, a currency strategist at Sydney-based Westpac Banking Corp., told Bloomberg that, “The dollar is likely to continue falling with the potential rate cut in the U.S.. The European Central Bank has a tightening bias, which puts them at a favorable differential to the U.S.”

Highlighting the longer-term decline of the greenback versus other currencies was the International Monetary Fund (IMF) announcement today that the dominance of the U.S. dollar as the world’s reserve currency is declining as the euro becomes more popular, especially among developing countries. The IMF found that, “Nonindustrial countries hold some 30 percent of their reserve assets in euros and 60 percent in dollars (as of December 2006), compared with 19 percent and 70 percent, respectively, six years ago.” Developed nations are also adding euros to their currency holdings. “Industrial countries’ use of the euro has risen to 21 percent from 17 percent in December 2000, while their dollar holdings have remained fairly steady at 72 percent compared with nearly 73 percent six years earlier,” according to the Washington, DC-based organization.

The importance of the U.S. dollar as the world’s reserve currency lies in the fact that the United States was able to run trade deficits exempt from free market forces that would have required an adjustment and a devaluation of the dollar. And what will happen if the dollar loses its reserve status? According to Peter Schiff in his book Crash Proof: How to Profit from the Coming Economic Collapse:

In any event, the U.S. dollar’s status as a reserve currency immune from market pressures cannot last indefinitely. When it ends, all those surplus dollars will come home to roost, creating hyperinflation domestically.

Got gold?

China’s Nuclear Option, Part 1

It started back on July 26. The U.S. Senate’s Finance Committee overwhelmingly approved legislation requiring the U.S. Treasury Department to negotiate with countries possessing “fundamentally misaligned” currencies. It would also impose trade penalties on countries that fail to take action, taking complaints to the World Trade Organization if necessary. The committee approved the legislation in a 20-1 vote. While the legislation doesn’t mention China by name, it is surely directed at them and is the result of bipartisan anger on Capitol Hill which claims the yuan’s peg to the U.S. dollar leaves the currency undervalued, to the detriment of American exporters. “There is no doubt that China and other nations have been undervaluing their currency to give themselves an advantage,” said Senator Lindsey Graham (South Carolina) in MarketWatch on July 26. “For too long the game has been rigged against American business. Working together we will change currency practices to put American business on a level playing field.”

This past Tuesday, Senator Max Baucus of Montana announced that the U.S. Congress will pass currency legislation to ease U.S.-China trade imbalances regardless of efforts by the Bush administration to address the problem. Senator Baucus said he appreciated U.S. Treasury Secretary Henry Paulson’s work to persuade the Chinese government to appreciate its currency, the yuan, but said such efforts were not enough. According to Reuters, Baucus declared, “No country out of the goodness of its heart ever lowers a trade barrier, ever… We in the Congress have to help China do what it knows it should do.”

Enter China. The Telegraph (UK) reported on Wednesday that two Chinese officials at leading Communist Party bodies have said that Beijing may use its $1.33 trillion in foreign exchange reserves (with $407 billion in U.S. Treasuries)
as a political weapon to counter pressure from U.S. legislators. Changes in Chinese policy are often announced through key think tanks and academies. Xia Bin, finance chief at the Development Research Center (which has cabinet rank), commented last week that Beijing’s foreign reserves should be used as a “bargaining chip” in talks with the United States. He Fan, an official at the Chinese Academy of Social Sciences, went even further yesterday, letting it be known that Beijing had the power to set off a dollar collapse if it choose to do so. Fan said:

China has accumulated a large sum of U.S. dollars. Such a big sum, of which a considerable portion is in U.S. treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced their dollar holdings. China is unlikely to follow suit as long as the yuan’s exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar.

Such action could trigger a dollar crash and larger U.S. financial crash at a time when the U.S. currency is already breaking down through historic support levels. Simon Derrick, the Bank of New York’s chief currency strategist in London, said the comments were a message to the U.S. Senate as legislation is prepared for the Autumn session. “The words are alarming and unambiguous. This carries a clear political threat and could have very serious consequences at a time when the credit markets are already afraid of contagion from the subprime troubles,” he said.

However, other financial analysts who spoke to the Washington Post today play down the threat of China using its “nuclear option,” as it’s sometime called. According to the Post, should China dump the dollar, thereby lowering its value, it would hurt its own pocketbook because it is such a large investor. “There would be turmoil in the financial markets… It’s not really a credible threat,” said Menzie D. Chinn, professor of economics at the University of Wisconsin. Even Treasury Secretary Paulson said He’s comments were “frankly absurd,” in a CNBC interview yesterday.

Peter Schiff, president of Euro Pacific Capital and author of Crash Proof: How to Profit from the Coming Economic Collapse, says there’s more to the currency issue than what’s made public. In his book he argues:

Hardly a month goes by without another U.S. government official or elected politician calling on the Chinese government to appreciate the yuan, which is currently pegged to the U.S. dollar. Such public browbeating is pure political grandstanding. It’s all a bluff. Privately, I am sure, we are begging the Chinese not to float their currency. China is the biggest buyer of U.S. Treasury securities, and the Chinese do it to defend the currency peg. They are also the biggest suppliers of low-priced consumer goods to Americans. Why on earth would American officials and politicians demand that China increase both consumer prices and interest rates in America? The result would surely be a severe recession.

Yet, the legislators carry on with their threats. Fortune reported that on Tuesday night Illinois Senator Barack Obama spoke before an AFL-CIO audience and said he would “take [China’s leaders] to the mat” for “manipulating their currency,” adding that huge U.S. deficits, financed in part by the Chinese, must end. “It’s pretty hard to have a tough negotiation when the Chinese are our bankers,” the Senator told a cheering crowd.

China has amassed a fortune through exporting cheap consumer goods to the United States and by purchasing U.S. securities to defend its currency peg, thereby keeping prices low. American consumers went ahead and bought inexpensive goods “Made in China” at our local Wal-Marts, helping keep consumer prices low but effectively making the Chinese our bankers. Unfortunately, China, now flush with U.S. dollar assets, possesses a “nuclear option” where it can trigger a U.S. financial crash should push come to shove. It is all too apparent that China has the upper hand in this situation, lest I remind the Senators of this and one other fact:

Be careful not to bite the hand that feeds you.

Crash Prophets, Part 3

In the previous “Crash Prophets” posts, we examined the U.S. economic outlook of key market watchers and investment legends. Today, the focus is on U.S. government and Federal Reserve officials, both past and present. Specifically, I am talking about former Treasury Secretary Robert Rubin, U.S. Comptroller General and Head of the U.S. General Accountability Office David Walker, and former Federal Reserve Chairman Paul Volcker.

Robert Rubin served as Treasury Secretary under President Bill Clinton. On January 22, Rubin appeared on the Charlie Rose television show and talked about the U.S. economy becoming increasingly unsound, and the need for “excruciating decisions” to be made. He explained, “I think we face [huge] challenges. I think we can do very well in what is really a transformed global economic environment with the rise of China and India. But… I think we’re on the wrong track on almost every front right now, regardless of how you allocate the political responsibility, and what I’d like to see the new Congress do- and I think they’ve gotten off to a very good start in this respect- is to address those challenges.” Rubin added, “I think we’ve got to re-establish sound fiscal conditions… so we have an environment conducive to growth, and also to avoid the dangers that, as [Federal Reserve Chairman] Ben Bernanke said very recently in his congressional testimony, [underlie] unsound fiscal conditions. I think that’s a tremendous threat to the global economy.” Regarding the deficit and its threat to the dollar, the former Treasury Secretary predicted, “If the current account deficit doesn’t change, then at some point something is going to have to give. It seems to me that it’s very likely there’s going to have to be an adjustment of the dollar. The way to minimize the adjustment that you need is to have sound policy.” In a videotaped message for a dinner hosted by the Concord Coalition in New York last November, Mr. Rubin emphasized that the U.S. budget situation needed to be addressed now because the government was just 5 years away from “rapid acceleration” in spending related to Social Security and Medicare.

The tremendous financial burden brought on by entitlements also frightens David Walker, who is basically the nation’s accountant-in-chief. Walker is touring the United States through the 2008 elections, and according to Bloomberg, is “talking to anybody who will listen about the fiscal black hole Washington has dug itself, the ‘demographic tsunami’ that will come when the baby boom generation begins retiring and the recklessness of borrowing money from foreign lenders to pay for the operation of the U.S. government.” His speaking tour includes economists and budget analysts from across the political spectrum. The message they are conveying is that if the U.S government continues to conduct business as usual in the coming years, the national debt ($8.8 trillion as of today) could reach $46 trillion or more, adjusted for inflation. Every year of inaction adds $2 trillion to $3 trillion, according to Walker. With the first baby boomers becoming eligible for Social Security in 2008 and for Medicare in 2011, the expenses for these two programs are about to increase significantly. In addition, the U.S. government has spent the last few years racking up debt and borrowing money from foreign lenders. If overseas investors lose their enthusiasm for purchasing U.S. debt, the result will be higher interest rates in the United States. A large jump in interest rates would be a disaster, in which case some economists predict the federal government would print money to pay off its debt, leading to runaway inflation.

Known for his stance against inflation, Paul Volcker was Federal Reserve Chairman from 1979 to 1987 and the predecessor of Alan Greenspan. At a dinner hosted by the Concord Coalition in New York last November, Volcker predicted that the United States’ dependence on foreign money raises the risk of a crisis in the dollar as soon as the next two and a half years. He said, “It’s incredible people have gone on so long holding dollars… At some point, you will get a situation where people have had enough.” Foreign investors now own about half of the $4.4 trillion of Treasuries outstanding. On April 10, 2005, Volcker talked about the U.S. economy in the Washington Post, and said, “Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks— call them what you will… What really concerns me is that there seems to be so little willingness or capacity to do much about it.” He added, “As a nation we are consuming and investing about 6 percent more than we are producing. The difficulty is that this seemingly comfortable pattern can’t go on indefinitely… I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.” Finally, Volcker speculated, “I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.”

Robert Rubin, David Walker, and Paul Volcker insist that the U.S. government must act now to prevent a U.S. financial disaster. As the former Federal Reserve Chairman recalled, “A wise observer of the economic scene once commented that ‘what can be left to later, usually is— and then, alas, it’s too late.’ I don’t want to let that stand as the epitaph of what has been an unparalleled period of success for the American economy and of enormous potential for the world at large.”

Crash Prophets, Part 2

In yesterday’s blog post, I talked about how some market watchers, specifically Richard Bookstaber, Peter Bernstein, Jeremy Grantham, and Gary Shilling, are warning of a fast-approaching U.S. financial crisis. Continuing the theme of “crash prophets,” today’s post focuses on legendary investors George Soros, Warren Buffett, and Jim Rogers, and what each is saying about the future of the U.S. economy.

George Soros is a Hungarian-born billionaire investor, philanthropist and author. The American businessman is known as “The Man Who Broke the Bank of England” as he earned $1.1 billion after speculating on the British pound in 1992, believing it was overvalued. He is also recognized for his involvement with the Quantum Fund, one of the most successful investment funds ever with an average annual return of 31% throughout its 30-year history. Back in January 2006, George Soros told an audience in Singapore that, “The soft landing (for the U.S. economy) will turn into a hard landing. That’s why I expect the recession to occur in 2007, not 2006.” Soros explained that a slowing U.S. housing market would be the catalyst for a U.S. recession in 2007. Back on June 2, 2007, AME Info quoted Soros as saying, “I believe the global economy has been sustained by a housing boom that took on the characteristics of a bubble,” and he cautioned, “I expect an initial soft landing to turn into a hard one when the slowdown does not end.” On the U.S. and global economy, “A slowdown in the United States will be transmitted to the rest of the world via a weaker dollar. That is why I expect a worldwide slowdown starting in 2007.” Finally, Mr. Soros stated that, “The savings of the world are sucked up into the center to finance over consumption by the richest and largest country, the United States. This cannot continue indefinitely and when it stops the global economy will suffer from a deficiency of demand.”

Warren Buffett, “The Oracle of Omaha,” is a famous investor, head of Berkshire Hathaway, and also the world’s second richest man. On October 26, 2003, Warren Buffet wrote a piece for Fortune entitled “Why I’m not buying the U.S. dollar.” Although a little dated, this article, and Buffett’s subsequent bet against the dollar, gives us insight as to where Mr. Buffett thinks the U.S. dollar and economy are going. Buffett said, “I started way back in 1987 to publicly worry about our mounting trade deficits — and, as you know, we’ve not only survived but also thrived. So on the trade front, score at least one “wolf” for me. Nevertheless, I am crying wolf again and this time backing it with Berkshire Hathaway’s money.” Regarding his actions on the U.S. dollar, he explains, “And my reason for finally putting my money where my mouth has been so long is that our trade deficit has greatly worsened, to the point that our country’s ‘net worth,’ so to speak, is now being transferred abroad at an alarming rate.” On the United States having avoided a financial crisis so far, Buffett says, “We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits. At a point, so it was claimed, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders. And that’s the way it has indeed worked for the rest of the world, as we can see by the abrupt shutoffs of credit that many profligate nations have suffered in recent decades. The U.S., however, enjoys special status. In effect, we can behave today as we wish because our past financial behavior was so exemplary — and because we are so rich. Neither our capacity nor our intention to pay is questioned, and we continue to have a mountain of desirable assets to trade for consumables. In other words, our national credit card allows us to charge truly breathtaking amounts. But that card’s credit line is not limitless.” Finally, Mr. Buffett closes with a warning to all those who think the trade deficit is just another obstacle that can be overcome. “We still have a truly remarkable country and economy. But I believe that in the trade deficit we also have a problem that is going to test all of our abilities to find a solution. A gently declining dollar will not provide the answer. True, it would reduce our trade deficit to a degree, but not by enough to halt the outflow of our country’s net worth and the resulting growth in our investment-income deficit.”

Jim Rogers is a legendary commodities trader who picked the bottom of the commodities bull market in 1999. He is also one of the co-founders of the Quantum Fund, along with George Soros. Of the three investors profiled, Rogers is the most vocal regarding the direction the U.S. is headed. In a Reuters article on December 16, 2006, Jim Rogers talked about the future of the U.S. dollar, and predicted, “It’s only a matter of time before the beleaguered U.S. dollar loses its status as the world’s reserve currency and medium of exchange.” He added, “The dollar is a terribly flawed currency… You should hold as few dollars as possible. The dollar’s decline would go on for years to come.” In an interview with iTulip on April 3, 2007, Rogers said that a U.S. recession will occur soon. “I see a recession, and for a variety of reasons. Automobiles are in recession. Housing is in recession. There’s been an inverted yield curve for a while. You have a slowdown in business spending. The subprime mortgage and junk bond markets are a disaster happening or waiting to happen in the financial area. There are plenty of things going on. Plus we’ve had recessions every four to eight years since the beginning of time, so there’s nothing unusual about the fact that we’re about to have another one.” On housing, Jim Rogers is especially bearish. In the same iTulip interview, he responded to a question about the housing downturn and the consensus of economists that the correction is largely over by replying, “It has a good long way to go because never before in American history have so many people been able to buy houses with no money down. Even during the 1920s when the banks first tried interest-only mortgages borrowers at least had to put some money down. This time a lot of borrowers have put no money down on interest only mortgages. The results will be much worse.” In a May 14, 2007, Reuters article, he predicts an eventual U.S. real estate crash. Rogers said, “You can’t believe how bad it’s going to get before it gets any better.” He adds, “It’s going to be a disaster for many people who don’t have a clue about what happens when a real estate bubble pops… Real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults. This time it’ll be worse because we haven’t had this kind of speculative buying in U.S. history.”

“When markets turn from bubble to reality, a lot of people get burned.”

To be continued…

April Trade Deficit: Nothing To Celebrate

Last Friday the Commerce Department reported that the U.S. deficit in international trade of goods and services (the trade gap) declined from $62.4 billion in March to $58.5 billion in April. The narrowing of the U.S. trade deficit by $3.9 billion prompted some economists to celebrate and raise their forecasts for economic growth going forward.

Source: U.S. Census Bureau

Miller time, anyone? Hardly. Glancing at the chart it becomes readily apparent that no progress has been made on reducing the trade gap over time. And the significance of April’s adjustment? Like Peter Schiff explains in his book Crash Proof, “Given the state of our economy, that’s like celebrating the fact that your kid brought home a report card with an F instead of an F minus.”

Americans continue to import much more than we export. But why should we care, since there have been no apparent repercussions of such actions? Because a sustained trade gap increases the danger of a financial crisis. The longer the U.S. trade deficit remains at high levels, the more Americans must effectively borrow from foreigners to pay for all of the goods we buy overseas. As our indebtedness to foreigners rises so does the danger that overseas investors might dump their dollars and unload their holdings of U.S. securities in a panic once they realize that the United States cannot repay all that debt. Last year, legendary investor Warren Buffett told business students and faculty at the University of Nevada-Reno that, “The U.S. trade deficit is a bigger threat to the domestic economy than either the federal budget deficit or consumer debt and could lead to political turmoil… Right now, the rest of the world owns $3 trillion U.S. more of us than we own of them… In my view, it will create political turmoil at some point. Pretty soon, I think there will be a big adjustment.”